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Competitive Advantage: Big Banks Blocking the Competition

Which banks have strong enough names to create an entry barrier for potential rivals?

Using the analysis laid out in Michael Porter's book Competitive Advantage, Motley Fool senior banking specialist John Maxfield and co-host Gaby Lapera dig into the telltale signs of Warren Buffett's favorite metric for identifying outstanding stocks: a durable competitive advantage.

Generally speaking, there are two ways for companies to acquire competitive advantages. The first is to become a low-cost provider, like Wells Fargo and/or U.S. Bancorp. This allows a bank to earn more money than its competitors even if they all face the same prices for their financial products and services. Alternatively, a bank can seek to differentiate its products and services based on quality, something that JPMorgan Chase and Goldman Sachs do in the investment banking space.

To learn more about competitive advantages in the bank industry, check out the video below.

Gaby Lapera: Do you want to talk a little bit about how this works out for financial institutions in general?

John Maxfield: If you want to talk about financial institutions, you're going to want to think about J.P. Morgan Chase or Goldman Sachs.

Lapera: Before we start, I just want to put in there that banking, financial stuff in general, insurance companies, REITs... all of these businesses have an extremely high barrier to entry. You have high capital costs, you have high regulatory requirements, you need to have a lot of knowledge, and people aren't going to give you their money if you don't know what you're doing.

In the industry, you're not going to have as much proliferation as you would in other industries such as the restaurant industry.

Maxfield: Yeah. That's a really important point to appreciate about the financial industry. You can't just open a bank if you wanted to just open a bank. Particularly after the Dodd-Frank and financial crisis, it costs so much and it's so complicated to get into banking nowadays. You really have to know what you're doing, and you have to have some money behind you to get in it. The industry dynamics are favorable in terms of entry barriers.

Now, within the industry, it's pretty commoditized. Unless you're able to differentiate yourself either on a cost basis like Wells Fargo has, U.S. Bancorp has done the same thing, M&T Bank has done it; the most recent Q1 cap financial was the most efficient bank in the recent quarter. If you can differentiate yourself in cost, that's probably the default way to go. The other way is, you've got to differentiate your product.

If you're talking about product differentiation in the banking field, the best area that you'll be able to identify that is in your wholesale products, your investment banking products, your trading products, and all those types of things. It would lean more toward your Wall Street operations, where brand and quality really make a difference. If you go into Goldman Sachs, you know you're going to get a quality product.

There's no question about it. Companies that need a serious thing done, whether it's a merger, an acquisition, advisory work, or something along those lines, then you'll go to Goldman Sachs or J.P. Morgan Chase. That's where that differentiation comes in for the banking sector, in particular.

Lapera: The other option is to excel in niche type banking things. What I have in mind is New York Community Bancorp (NYSE: NYCB). They specialize in multifamily loans in New York City. No one else is as good as them at doing that particular thing in that particular city.

Maxfield: Again, that's a perfect example. If you chase New York Community Bancorp's stock back to 1994 when they IPO'd, it's one of -- if not the highest -- performing bank stocks over that time period. The reason is, to your point, because they focused on this niche area and you can analogize that to being a local monopoly, almost like a utility even though it doesn't have the same level protection you can analogize it to; that allows it to generate these higher returns on their banks.

Another great example of a niche bank that is able to generate outsized returns is SVB Bank out in Silicon Valley. They focus on helping brand-new start-up technology firms in getting financing and the financial products and services that they need in order to operate and succeed. Nobody really does it as well as SVB Bank.

So just like New York Community Bancorp, you're dealing with a niche market that allows it to generate almost monopoly-like outsized returns that then translate into higher shareholder returns over an extended period of time.

Lapera: Exactly. Just to wrap up this episode, investors; when you're looking at investing in a company, take a look at what the industry dynamics are for competitiveness. Look at the company that you're thinking of investing in and asking, "Do they have a pricing advantage? Do they have a differentiation advantage? Is it something that can last over a long period of time? Is it something that just gives them an advantage right now?" Do you have anything you want to add?

Maxfield: The only thing I would say is to keep in your head that the single most -- not everyone will have time to go out and read Porter's book tomorrow, and it's a difficult book to read -- but the concept is what matters so much here. That is, when you're picking an investment, look for companies that can in some way, shape, or form be perceived as having a competitive advantage. Whatever that means to you. If you can find those, that's where you're going to have your investment winners.

Gaby Lapera has no position in any stocks mentioned. John Maxfield has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool has the following options: short January 2016 $52 puts on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.